derivatives in financial markets

Derivatives in Financial Markets

William F. Sharpe

STANCO 25 Professor of FinanceStanford Universitywww.wsharpe.com

XXXV Conference, “I fondi pensione nella XXXV Conference, “I fondi pensione nella crisi dei mercati finanziari” 22 Giugno 2009crisi dei mercati finanziari” 22 Giugno 2009

The Dojima Rice ExchangeOsaka, Japan

The Panic of 1720

“... (in 1716, John Law) introduced the practice of dealing in “futures”. This led to dealing in “puts” and “calls” as well as buying and selling on margins.

… There was an era of sudden wealth, wild extravagance and inflated prices.

… Good faith had been swamped by the delusion conjured up by dazzling visions of immediate wealth.

“(the Panic of 1720 was) …due to an inflation of currency and an over-expansion of credit which came from a mingling of sound ideas not fully understood with unsound ones …”

Source: the New York Times, Feb. 25, 1900

John Law and the Panic of 1720

A Derivative

• Counterparty:– “Give me some money now and I will

promise to give you some money later*”

• Conditions– “The amount I will pay will depend on the

value of some underlying security or outcome in the following way ….”

* if I can

Derivative Terms

exfy ~)~(~

y : payoff

x : underlying

f(…) : payoff function

e : counterparty risk (>=0)

A Payoff Function

Counterparty Risk

Narvik, Norway

Karen Margrethe Kuvaas is the mayor of Narvik,one of four Norwegian municipalities that suffered heavy losses when investments linked to the American subprime mortgage market soured.

Lehman Zertifikates“When Lehman collapsed it took with it about 500 million Euros that belonged to 60,000 small investors”

Dresdner Bank + Bank Adviser = Lehman Victim

Lehman Zertificates

Sold by banks (Dresdner, Citibank, Frankfurter Sparkasse)

Example: - yearly payouts based on how high the DAX rose, - limited losses if the DAX fell

A bearer bond issued by Lehman “.. All major ratings agencies gave Lehman good marks until it collapsed”

Source: The New York Times, October 15, 2008

Hong Kong Banks to Buy Back Lehman Minibonds

A man who invested in Lehman Brothers minibonds was among those who protested outside the Bank of China in Hong Kong this month.(Bobby Yip/Reuters)

Lehman Minibonds

Product Summary

This product is designed for defensive investors seeking exposure to high grade assets that provide steady coupons

and enhanced yields. Investors can gain exposure to thecredit risks of the reference entities without directly holdingthe debt obligations of the reference entities and without

involving any reference entity in the transaction.

The Economist, Nov. 20, 2008

“Asian pensioners are the latest victims of Lehman’s bankruptcy …

From 2006 onwards, banks and brokers sold … [minibonds] to individuals desperate to earn more than the 1% or less on guaranteed deposits…

Buyers were betting on modest returns, typically 5-6%, low enough perhaps for them not to have been too suspicious about the instruments’ complexity…”

The Economist (continued)

“ Although many different securities were affected, they shared a common trait: fiendish complexity…

One firm would arrange the structure and handle dividend payments. This was often Lehman…

Below the arranger were half a dozen or so “reference” banks which held collateralised-debt obligations and sometimes equity, issued by as many as 100-150 institutions.

Corporate Securities as Derivatives

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Corporate Stock as a Derivative

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Financial Engineering

TK-1 Transgenic Flourescent Fish

Taikong Corp. Taiwan, 2003

“In a logically consistent world, financial engineering … would be the study of how to create financial devices … that perform in desired ways.”

Emanuel Derman, “Models”, 2008

Key Derivative Characteristics

ComplexityTransparency

LiquidityLeverage

“ (These) … have all played a huge role in this crisis…. And these are things that are not generally modeled as

a quantifiable risk.”

– Leslie Rahl, Capital Market Risk Advisors(NY Times, Nov. 5, 2008)

Leverage and Collateral

• Leverage– Percentage change in derivative value per 1%

change in the value of the underlying

• Collateral– Assets pledged by a borrower to secure a loan or

other credit and subject to seizure in the event of default.

• Investorwords.com

What Can Go Wrong?

Promised Payments

Property Value Promised+30 % $110+20 % $110+10 % $110 0 % $110-10 % $110-20 % $110-30 % $110

Actual Payments

Property Value Actual+30 % $110+20 % $110+10 % $110 0 % $110-10 % $100-20 % $90-30 % $70

Erroneous Payoff Predictions

Property Value Predicted Actual+30 % $110 $110+20 % $110 $110+10 % $110 $110 0 % $110 $110-10 % $100 $100-20 % $100 $90-30 % $90 $70

Missing Scenarios

Property Value Predicted+30 % $110+20 % $110+10 % $110 0 % $110-10 % $100-20 % $90

AIG Financial Products Division

• “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing a dollar in any of those transactions”

– Joseph J. Cassano, President, August, 2007

Standard & Poor’s Rating Agency

• [Steve Eisman] called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up”.

– Michael Lewis, New York Times, Nov. 11, 2008

Erroneous Probabilities

PredictedProbability Probability Property Value Actual

0.15 0.10 +30 % $1100.24 0.20 +20 % $1100.30 0.30 +10 % $1100.20 0.20 0 % $1100.10 0.10 -10 % $1000.009 0.07 -20 % $900.001 0.03 -30 % $70

Russian Roulette

• “The probability of a disastrous outcome appeared to be so low that it was ignored in the models used by the issuers and raters.

• But even a low probability event may represent an unacceptable risk.

• Few of us would play Russian roulette, even if the odds were wildly in our favor, because it is a game no one can lose twice.”

Floyd Norris, New York Times, Nov. 7, 2008

Assets and Liabilities

Promised ActualProperty Value Asset Liability Liability Net Worth

+30 % $140 -$110 -$110 $30+20 % $130 -$110 -$110 $20+10 % $120 -$110 -$110 $10 0 % $110 -$110 -$110 $0-10 % $100 -$110 -$100 $0-20 % $90 -$110 -$90 $0-30 % $70 -$110 -$70 $0

Lack of Transparency

Promised ActualProperty Value Asset 1 Asset 2 Liability 1 Liability 2 Liability 2

+30 % $140 $140 -$105 -$110 ??+20 % $130 $130 -$105 -$110 ??+10 % $120 $120 -$105 -$110 ?? 0 % $110 $110 -$105 -$110 ??-10 % $100 $100 -$105 -$110 ??-20 % $90 $90 -$105 -$110 ??-30 % $70 $70 -$105 -$110 ??

Systemic Risk

Counterparty 1 Counterparty 2Property Value Asset 1 Other Liab Deriv. A Deriv. A Other Liab. Deriv. B

+30 % $140 -$10 -$105 $105 $0 -$105+20 % $130 -$10 -$105 $105 $0 -$105+10 % $120 -$10 -$105 $105 $0 -$105 0 % $110 -$10 -$100 $100 $0 -$100-10 % $100 -$10 -$90 $90 -$15 -$75-20 % $90 -$10 -$80 $80 -$20 -$60-30 % $70 -$10 -$60 $60 -$40 -$20

Systemic Risk with no Transparency

Counterparty 1 Counterparty 2Property Value Asset 1 Other Liab Deriv. A Deriv. A Other Liab. Deriv. B

+30 % $140 -$10 -$105 $105 $0 -$105+20 % $130 -$10 -$105 $105 $0 -$105+10 % $120 -$10 -$105 $105 $0 -$105 0 % $110 -$10 -$100 $100 $0 -$100-10 % $100 -$10 -$90 $90 -$15 -$75-20 % $90 -$10 -$80 $80 -$20 -$60-30 % $70 -$10 -$60 $60 -$40 -$20

Dynamic Strategies

Beta by Path

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Subject to Model Risk

Exchange-traded Derivatives

• Standardized• Regulated • Provide price discovery• Daily mark-to-market value adjustments• Margin deposits• Position limits• Centralized clearing system guarantees• Offsetting positions clear original contracts

Counterparty Risk

• Added risk due to the possibility that the provider of a financial instrument will not deliver the promised amount on time and in full

• Counterparty risk can be present for– Annuities– Derivatives– Any financial contract in which another party has

promised to make a payment in the future

Mitigating or Avoiding Counterparty Risk

Ex Post Bailouts

Subject to Moral hazard “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.” - Wikipedia

Attributes of Financial Instruments with Minimum Ex Ante Counterparty Risk

• Transparent

• Collateralized

• Audited

• Regulated

Providing Upside Potentialand Downside Protection

• Trust Account– Underlying asset pool

• e.g. the world market portfolio– Audited– Regulated

• A single maturity date• Share Classes

– Different payoff patterns– Participation unambiguous with oversight– Proportions add to 100% in every scenario

M-Shares

Source: W. F. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice, 2007

Henri de Tonti

• American Explorer

• Son of Lorenzo de Tonti, Neapolitan banker and creator of the first Tontine in France, 1653

An Annuity Tontine

• A single maturity date• All investors have the same birth year• Investments are irrevocable• Fully collateralized• Transparent, audited and regulated• Share Classes

– Participation unambiguous with oversight– Proportions add to 100% in every scenario

• Payments made only to living investors

After the Panic

What Might Change

• Derivatives– Less complexity

– More transparency

– Reduced counterparty risk

• Institutions– More regulation

– More auditing

• Rating agencies: greater independence

• Institutions too big or too interconnected to fail– More explicit identification ex ante

– More regulation and auditing